Tuesday, October 25, 2011

Liquidity, Solvency, and Competitiveness

Kantoos considers whether it is obvious that the eurozone debt crisis is, at least with respect to Spain and Italy, merely a liquidity crisis and not an issue of fundamental insolvency:

The problem is how to distinguish a multiple-equilibria situation from cases of genuine one-equilibrium insolvency – especially for countries as the future capacity to repay is not based on assets in a narrow sense but on the expectation of future economic growth.

...For Italy and Spain, there is a reasonable chance that it is in fact a self-fulfilling liquidity problem, but – and that was my main point – it is by no means certain. A backward-looking remark about Italy having a primary surplus is just not enough to make your case and Henry’s analysis is not encouraging.

A few points. First, take a look at the following chart that shows the debt/GDP ratios for a number of major European economies. See if you can tell which country is Spain. (All data is from Eurostat.)

If the markets believed that Spain (the blue line) is fundamentally insolvent -- or even at risk of becoming fundamentally insolvent in the foreseeable future -- then wouldn't such solvency concerns have also hit the debt of Germany, France, and the UK? (Those are the other three lines in the chart.) Given this, it seems overwhelmingly likely to me that the market's nervousness about Spanish debt is of the nature of a self-fulfilling "illiquid-but-solvent" crisis.

And what about Italy? Italy's debt/GDP ratio is indeed high -- over 100%. But that ratio has been over 100 percent for the past 20 years, so that's nothing new. And in recent years, Italy's budget deficit has been relatively small, as seen below.

Again, it seems far from obvious from this why market participants would have become worried about Italy's insolvency but not that of France or the UK.

There are two factors that Spain and Italy do have in common, however, that sharply distinguish them from France, Germany, and the UK. The first is that they do not have a central bank to provide unlimited liquidity to the government if necessary. The UK clearly does, by contrast, and I think most people would expect that the ECB would also perform that function for Germany if necessary. France is in a bit of a grey area there, which is exactly why the markets have inserted some additional risk premium into French government bond yields in recent months.

The second factor is the long run issue that Kantoos draws attention to: the competitiveness problem. The UK has no such problem, because its flexible exchange rate will automatically adjust its competitiveness to match the amount of financing it is able to attract; if investors become less willing to finance the UK's debt, the pound will lose value and the UK will start to gain competitiveness. Germany has no such problem, because it has undergone a steady improvement in its relative competitiveness ever since the adoption of the euro. And France is much closer to Germany than to Italy as far as competitiveness goes.

But where I would disagree with Kantoos is his assessment that Germany's improvement in competitiveness during the euro period was policy-driven, and that Italy and Spain's competitiveness problems are the result of their unwillingness to tackle the problem.

The changes in competitiveness in each of the eurozone countries during the years leading up to this crisis were driven by capital flows within the eurozone. Countries that received large capital inflows saw their prices rise in relative terms and their competitiveness worsen, which in turn helped to bring about the current account deficits that are the counterpart to those capital inflows. Conversely, countries that sent capital abroad saw their relative prices fall and competitiveness improve, for the same reason. Policy had little to do with competitiveness changes; they were a macroeconomic necessity entailed by the flow of capital from capital-rich countries like Germany to capital-poor countries like Spain.

The following table ranks the major eurozone countries in order of their current account balances between the adoption of the euro in 1999 and the onset of the financial crisis in 2008. Using total changes in the price level to provide a quick-and-dirty estimate of changes in competitiveness, it's clear that the relationship between the two is very strong -- countries that experienced capital inflows saw their price levels rise and their competitiveness worsen. The implication is that in the absence of policies to stem the inflow of capital, there was probably nothing they could have done to prevent that.

To summarize: Spain and Italy seem quite clearly to be the victims of a self-fulfilling illiquid-not-insolvent sort of crisis. They are in this situation because the markets have doubts about the willingness of a central bank to provide unlimited liquidity, unlike the case with Germany or the UK. And in addition they face a competitiveness gap with Germany that has arisen not out of any specific policies in Germany, Spain, or Italy, but that instead is the direct result of the massive capital flows from the northern eurozone to the southern eurozone that took place during the 2000s.

The eurozone therefore faces both a short run problem (the self-fulfilling liquidity crisis) and a long run problem (the competitiveness issue). There are fairly clear policy prescriptions for both. The primary question at this point is whether Europe's policy-makers will act on them.

11 comments:

"where I would disagree with Kantoos is his assessment that Germany's improvement in competitiveness during the euro period was policy-driven"

Actually, Kantoos is right especially in this respect. Since at least 1998 all German governments, without exception, followed a policy which led to significant reductions in real incomes especially of the middle class, and to huge cuts in social benefits.

The gain in the relative competitivenes of Germany was thus paid for by the working class. If this process was not policy driven, none ever was. You might want to get some more hard fact info about the politics in Germany during the past 13 or so years.

I have been reading about your theory where capital inflows from the stronger euro members have now stopped and reversed, leading to capital outflows from these countres, higher deficits and unemployment. While capital outflows can certainly explain a large portion of growth in countries like Greece, Italy, Portugal and Spain, it cannot be the only factor that has caused such as divergence between the peripheral countries and the core countries in this debt crisis.

There are massive structural differences between a country like Germany and Greece. Greece is overly dependant on the public sector while Germany is dependent on foreign markets for growth. The taxation system in Greece is completly corrupt, taxes are not paid and the only way they are now trying to levy them is through an electricity bill. Peripheral countries are also less competitive because government policy has restrained the private sector, nationalized industries and created unproductive legislation leading to a disadvantage vis a vis more competitive euro countries. Countries like Greece and Italy are plaugued by governmental corruption and bureaucratic inefficiency.

Lastly Greece was growing at a very fast GDP rate before the crisis, yet they still managed to maintain high debt when they should have been paying this down in good times...

I like your blog and am hoping you might help me clear something up. I'm a physicist by training and write a blog called The Physics of Finance (http://physicsoffinance.blogspot.com/).

I'm puzzled about how much information is actually made public (through the BIS, for example) about banks' exposures through CDS contracts. You had a great post in June writing about some BIS data which, at face value, looks fairly complete. Are financial institutions required to report CDS exposures to the BIS?

I'm puzzled because I read yesterday on Simon Johnson's blog (http://baselinescenario.com/2011/10/23/european-debt-the-big-picture/) that perhaps it is not so straightforward:

"Cross-border bank exposures through loans and other holdings are publicly disclosed – data from the Bank for International Settlements are represented by the arrows in the NYT graphic. These data are surely not perfect, but they do convey the main points and they tell you where to focus attention.

Why do we not require publication of similar data, preferably by financial institution, for all derivative transactions – including both gross and supposedly net exposures across borders?"

I guess the point he is making is that the data from BIS lacks the resolution required to identify particular institutions which might be at high risk. Rather, it's aggregated data for between country explosures. So actually -- ignore the question as I think I've answered it myself! Are institutions required to report their CDS exposures to any national authority?

<span>Re: your summary.</span><span>This is a situation similar with that in my country in the Eastern Europe (non-euro-zone). The IMF however tells my govt. that the solution is to sell the state companies to the investors or to arrange private management to the state companies and to boost exports of anything that can be exported for euros or dollars. </span><span></span><span>Why is this asset-grabbing, rent extracting policy showed on our throats by the IMF and how is it different from what is being done in Spain and Italy? </span><span>Thanks.</span>

<span>Re: your summary.</span><span>This is a situation similar with that in my country in the Eastern Europe (non-euro-zone). The IMF however tells my govt. that the solution is to sell the state companies to the investors or to arrange private management to the state companies and to boost exports of anything that can be exported for euros or dollars. </span><span></span><span>Why is this asset-grabbing, rent extracting policy showed on our throats by the IMF and how is it different from what is being done in Spain and Italy? </span><span>Thanks.</span>

<span>Re: your summary.</span><span>This is a situation similar with that in my country in the Eastern Europe (non-euro-zone). The IMF however tells my govt. that the solution is to sell the state companies to the investors or to arrange private management to the state companies and to boost exports of anything that can be exported for euros or dollars. </span><span></span><span>Why is this asset-grabbing, rent extracting policy showed on our throats by the IMF and how is it different from what is being done in Spain and Italy? </span><span>Thanks.</span>

<span>Re: your summary.</span><span>This is a situation similar with that in my country in the Eastern Europe (non-euro-zone). The IMF however tells my govt. that the solution is to sell the state companies to the investors or to arrange private management to the state companies and to boost exports of anything that can be exported for euros or dollars. </span><span></span><span>Why is this asset-grabbing, rent extracting policy showed on our throats by the IMF and how is it different from what is being done in Spain and Italy? </span><span>Thanks.</span>

<span>In fact the rule is quite simple : nominal rates ( risk free adjusted) have to match nominal growth ( in fact, these of investment ). In the long run, or at the global level ( or in a close economy), it always does.</span><span></span><span>Let's say the nominal rates are 1 point lower than nominal growth of investment, the current account will deteriorate by roughly 0.2 * 1 = 0.2 percentage point of GDP every year. Same goes for the currency against an adjusted basket of others.</span><span></span><span>During the 2000s, rates were roughly the same across EZ countries. But some had a far higher nominal growth than let's say Germany. So the trajectory between their respective current account could only diverge through the time. This divergence keeping on amplifying as long as the rates were in mismatch was nom. growth.</span><span></span><span>And yes, politics could not have changed anything to it. It was the financial markets that were setting these rates.... Now they are trying to fix it, but too fast.</span><span></span><span>The real problem is not a fiscal problem, it is a current account imbalance due to mismach of market rates vs growth across the EZ.</span><span></span><span>Also, needless to say that the UK and the US are in an equivalent mismatch of their rates, and that probably once the EZ will have solved its problems, both the dollar and the pound are going to fall fast vs the euro while rates may adjust inversely.</span>

<span>Also, the deterioration of the current account is structural, which means it is slow to kick in but also difficult to reverse since it requires rates to be higher than growth for an equivalent period.</span><span></span><span>It differenciates from the conjonctural one which is the simple lack of interest for savings ( due to low yield) vs cheap cost of borrowing, which can be reversed quickly. </span>

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The Street Light is written by economist Kash Mansori, who works as an economic consultant (though views expressed here are entirely his own), writes whenever he can in his spare time, and teaches a bit here and there. You can contact him by writing to the gmail account streetlightblog. (More about Kash.)